Dark Pools

Dark Pools

Financial exchanges are the market places where buyers and sellers of financial securities trade (buy and sell). The exchanges have become automated and electronic over time leading to rise in trading volumes. The exchanges do three main things,

1. Match trades – i.e. create order book per financial security (with bids and offers of all buyers and sellers) and match trades when the trading conditions (financial security, price, quantity etc. is matched)

2. Distribute market data – send out the market prices and order books of all financial securities to all its members (brokers) in the market

3. Surveillance- Just ensure orderly market behaviour and meet all the regulatory requirements

Whenever an investor sends their trade in the market, it is distributed as market data to everyone else and broadly everyone is aware of open and executed trades in the market. Some institutional investors (larger fund managers etc.) are more comfortable trading their orders without necessarily disclosing it to the whole market before the trade. They are more comfortable sharing the information after the trade is done. This led to the rise of an exchange that matches trades, does the appropriate surveillance but does not distribute market data. This is called a Dark Pool. So nobody can see who all is trading which financial securities and in which quantities and at what prices, at least before the trade is done. After the trade is matched, the dark pool can share that information in the public domain (called as post-trade reporting).

Many a times, the trade is executed at a price which is half way between the bid and offer and a normal stock exchange, so its publically reference-able. The benefits here include reduced market impact prior to trade execution which is very desirable for the institutional investors. But since the trades are being done in the “dark” they just need to be monitored well by the regulatory authorities. Baikal was a smart dark-pool that was innovated by Lehman Brothers in executed along with some other partners including London Stock Exchange that managed dark executions (for smaller orders as well as larger execution orders using Time Weighted or Volume Weighted average prices, had smart router to execute any unfilled orders on the other exchanges, and had smart anti-gaming logic to avoid anybody trying to game the system.